WASHINGTON (MarketWatch) — Derivatives regulation currently being drafted by regulators and a tougher Volcker rule will be enough to prevent other banks from suffering losses similar to J.P. Morgan Chase & Co.’s surprise $2 billion-plus trading loss, the co-author of the financial reform law told MarketWatch on Friday.

Rep. Barney Frank, whose name is shared on the Dodd-Frank Act implemented in the wake of the 2008-09 financial crisis, said that so far he doesn’t see a need for legislation to break up the big banks, and took issue with concerns raised by critics that argue there would be political pressure to bail out financial institutions in another crisis.

Here’s what the top Democrat on the House Financial Services Committee said.

MarketWatch:
Legislation was recently introduced by Democrats Sen. Sherrod Brown of Ohio and Rep. Brad Miller of North Carolina that would reduce the size of banks. Their argument is that J.P. Morgan’s /quotes/zigman/272085/compositeJPM-0.62%
losses may end up being much more than $2 billion, and that such trades would be systemic in a more-skittish market. Do you think the legislation is warranted?

Reuters

Rep. Barney Frank of Massachusetts

Frank:
At this point I don’t see a need for it. Even if you think that is a good idea, we are not yet in a point with the economy in the state it’s in and where we are trying to get lending restarted that we should do that.

Also, what we have are good rules coming into place about transparency, exchanges for the derivatives market and margin requirements on derivatives. In fact, [former Commodity Futures Trading Commission chief of the Division of Trading and Markets] Michael Greenberger said if the legislation on derivatives had been in effect, people would have seen this coming and the market would have been able to react before it got to this point.

People are focusing too much on whether [the trading] was done by a bank or a nonbank. Derivatives issues weren’t just within banks. A very important part of that legislation puts constraints on derivatives trading, and particularly someone getting so overloaded on derivatives that they can’t pay and it’s destabilizing. One, J.P. Morgan wouldn’t have been able to do that, and two, there would have been warning well before this.

Q:
Another area some lawmakers are concerned about is the way the Federal Reserve and other regulators interpret the Volcker rule, which is designed to prohibit speculative trading by big banks. Some senators say the regulators’ proposal allowing for portfolio hedging is a large loophole for continued speculative trading.

A:
A portfolio hedge is not a hedge; it is a speculative bet. A hedge is aimed at being neutral on a particular asset, aimed at neither losing or gaining. They are trying to make money. The hedge is to take the risk out. I agree that is a problem.

Q:
Tom Hoenig, a new Republican member of the Federal Deposit Insurance Corp., has an idea that would also try to break up the banks, separating the broker-dealer unit from the commercial bank, but continuing to allow the commercial bank to conduct investment banking and underwriting. Does such an approach have merit?

A:
To do anything structurally right now in an economy that is trying to recover, I think it would be a mistake to do it now. Secondly, this is a problem of derivatives.

Q:
A number of critics wonder whether there would be political pressure to keep a financial institution going in another crisis that the requirement that it be resolved using Dodd-Frank could be overridden. What do you think?

Inside the chaos at J.P. Morgan

Monica Langley offers a behind-the-scenes look at the chaos that enveloped J.P. Morgan as CEO Jamie Dimon struggled to come to grips with a trading debacle. (Photo: Bloomberg)

A:
There are people that think it will lead to “too big to fail” because [the financial firms] will be bailed out. I disagree. Couldn’t be more wrong.

If an institution can’t pay its debts, it’s out of business and shareholders are wiped out. It is taken over by the FDIC and if any money has to be spent in the course of resolving it, that money is recovered from institutions with $50 billion in assets or more. Anybody who thinks there would be overwhelming demand to keep a failing institution going with public money is crazy.

Q:
Part of the concern is that with a failing megabank there would be taxpayer-funded bailout of creditors — with a haircut and some losses — of the institution, and that is driving the bond market and rating agencies to believe these institutions carry less risk than their smaller rivals

A:
Maybe. Moody’s is rethinking that. There is also a higher capital charge for big banks. That’s a separate issue.

Q:
What about the liquidity-facilities provision in the statute that could be available as a form of taxpayer funding? Some have said that is a loophole.

A:
The statute takes away the power to extend money, and allows a liquidity facility to be set up for any institution that is clearly solvent but illiquid. It says that if the liquidity crisis is caused by the failure of someone else, then they can use it. They have to have a very high degree of certainty that they are solvent.

Q:
A number of people have raised concerns about how bank regulators permit J.P. Morgan to model its own risk using a value-at-risk calculation. J.P. Morgan’s Jamie Dimon noted that the bank changed its calculation at the end of the first quarter, something that former FDIC chief Sheila Bair said should have raised flags for regulators.

A:
We have capital standards that don’t depend on bank modeling. Secondly, we reduce value at risk in general derivatives regulation by requiring margin by the counterparty, and having transparency and going on exchanges. If the counterparty posted margin, then your value at risk diminishes.

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